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How to Invest in a Bond Market About to Be Flooded With New Debt

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Finding value in today’s bond market is a lot different from years past, says Rick Rieder, BlackRock’s global chief investment officer of fixed income.

Selling volatility and reducing credit quality don’t work because spreads are too tight and moving out on the yield curve doesn’t make sense when rates are rising. The 30-year Treasury bond, for example, is down 4% year to date.

“You have to run less risk today,” says Rieder, who spoke at a breakfast meeting with reporters. But unlike other strategists, Rieder isn’t cautious primarily because of expectations for rising inflation and consequently rising rates.

(Related: Bonds in Client Portfolios: What Advisors Need to Know)

“Inflation won’t rise that much,” says Rieder, who expects core CPI will peak at 2.5% and the core personal consumption expenditures index the Federal Reserve’s favorite inflation gauge slightly higher than 2%.  Most job creation is occurring in the service economy, which doesn’t have the same multiplier effect as job creation in goods-producing sectors, and business spending on software tends to limit price increases, reasons Rieder.

Rather than inflation, It’s the flood of new Treasury debt to fund a $1 trillion-plus U.S. deficit that worries Rieder. The deficit is expected to explode as a result of the recent tax cut bill.

“Net issuance of Treasury debt net will be unbelievable,” says Rieder.

Given this outlook, Rieder favors two-year Treasuries, whose rates near 2.3% are well above the dividend yield of the S&P 500, at 1.87%. “You get income for two years and don’t have to take credit risk or equity risk.”

(Related:  Vanguard Rolls Out New Emerging Markets Bond Fund)

Rieder also likes emerging market debt, which, according to his colleague Amer Bisat, offers “probably the best risk/reward fundamentals compared to developed markets” due to strong growth and better balance sheets that also compare well to their historical levels.

Moreover, central banks in emerging markets can still cut interest rates in the near to medium term while central banks in developed markets are either raising rates the Fed or maintaining current rates  the European Central Bank.

“Emerging market debt still has value, some more than others,” says Bisat, who heads  BlackRock’s sovereign and emerging markets alpha team. The weak dollar is also supportive of emerging market debt because many of those sovereigns owe dollar-denominated debt.

(Related: What Higher Yields Mean for Stock and Bond Portfolios)

Bisat favors two types of emerging market sovereigns: those with strong fundamentals but strong debt valuations to buy on dips, and turnaround stories.

In the first category are Russia, Indonesia and Brazil, although Bisat is cautious about Brazil’s upcoming election. The latter category includes Argentina “the election two years ago was a game changer”   South Africa, which has a new president, Cyril Ramaphosa, who replaced Jacob Zuma, who is on trial for money laundering and corruption; and Mexico.

He favors local-currency denominated debt for Russia and Indonesia, dollar-denominated debt for Argentina and both local and dollar-denominated debt for Mexico.

Despite these positives, emerging market debt is not without risks, notes Bisat. “Emerging markets live and die by developed market growth [because] their own growth depends on exports to developed markets, he says. “Anything that changes that story is bad for emerging markets.”


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